Question

Use the money market and FX diagrams to answer the following questions about the relationship between the Home and the foreign currency (E_h/f: home in terms of foreign; per unit (1) foreign currency).

Consider how a change in foreign Money supply affects interest rates and exchange rates.

On all graphs, label the initial equilibrium point A.

a) Illustrate graphically how a temporary decrease in the foreign Money supply affects the money and FX markets in the short run and in the long run.

Briefly explain your graphical results in words emphasizing the underlying mechanism that drives the results

b) Illustrate how a permanent decrease in the foreign Money supply affects the money and FX markets in the short run and in the long run.

Briefly explain your graphical results in words emphasizing the underlying mechanism that drives the results

Answer 1

a) temporary decrease in foreign money supply reduces demand for domestic goods which shifts DD1 to DD2 resulting in new equilibrium at es where output is lower at Y2 and exchange rate has depreciated to E2.

In the long run since the decrease was temporary, money supply increases back to its original position shifting DD2 back to DD1 and bringing the equilibrium at eL where exchange rate and output are back to their original level.

b) Permanent decrease in foreign money supply has same effects in the short run. In the long run adjustment changes. Decrease in demand for domestic goods leads to lower prices. Lower price increases real money supply which further leads to lower interest rate. Lower interest rate discourages capital inflow into the country. This shifts AA1 to AA2 resulting in depreciating the currency more to E3 but brings the output to its initial level.